As world leaders come together at the UN Climate Change Conference, the recent and dramatic spike in energy prices promises to be at the center of the debate. So far, two competing schools of thought have emerged to explain the current crisis: either the transition to renewables is moving too fast or it isn’t moving fast enough. While governments will certainly need to take steps over the coming months to buffer their citizens and industries from the worst effects of high energy costs, it’s important to keep in mind that today’s price reflects only a momentary mismatch between supply and demand. As technological developments, government policy, and consumer preference continue to drive the substitution of fossil fuels for more price-stable renewables, we can expect today’s high energy prices to reverse course, eventually collapsing to a fraction of today’s prices. Perhaps nowhere is this more certain than in the oil market, where the adoption of electric vehicles augurs a crash in crude prices and spells trouble for producers.
Key to this analysis is the observation that oil prices are uniquely sensitive to changes in demand. For the better part of the last century, a mostly inelastic and steadily growing demand for petroleum products has run up against limited supply, bidding up price well above mean production costs and resulting in windfall profits for producers (called a ‘scarcity premium’). When demand softens, or dramatically buckles as it did with the onset of the global pandemic, price responds disproportionately, sliding down a near asymptotic supply curve as the bubble bursts. This helps explain what happened during the 2008-2009 Recession when, over a six-month period, a three percent drop in oil demand corresponded with a seventy percent drop in price, bottoming out below forty dollars per barrel. Similarly, last year, a sudden drop in demand brought about an exponential drop in price, even briefly resulting in negative oil futures.
In both cases, price rebounded fairly quickly (in fact, we’re currently in the middle of just such a robust recovery). But what happens to price when the demand change isn’t temporary, but instead part of a systematic and continuous process of demand destruction? Put another way, what will the mass adoption of electric vehicles mean for oil prices?
To begin answering this question we can look back to the late 1970s and '80s when a series of oil crises encouraged the US and other countries to reduce their demand for oil. Through a combination of government legislated fuel efficiency standards and consumer preference for more fuel-efficient Japanese cars, global oil demand dropped for over a decade and, as a result, Brent crude remained below forty dollars per barrel for over twenty years. (Inflation adjusted) The point to grasp is that while temporary mismatches in supply and demand can cause energy prices to spike, long-term trends in technology, regulation, and consumer preference cause price to collapse and continue to assert downward pressure on price for decades to come. In a world quickly switching to alternative transportation fuels, EVs don’t merely represent a demand detour for oil companies, but rather the end of the road.
Low oil prices are socially desirable for several reasons. First, cheap oil results in cheap gas and diesel for anyone still driving legacy ICE vehicles. We might view this as a ‘green dividend’ for customers who overpaid into Big Oil’s ‘scarcity premium’ for so many years and would mean trillions of dollars of savings over the next decade. Second, the lower the expected return on investment, that less oil firms invest in projects that are disastrous for life on Earth. As the International Energy Agency made clear in a recent report: continued investment in new oil fields would make adhering to the Paris Accords impossible and put us on the path toward runaway global warming. Third, low prices will force oil companies to diversify into renewables quickly or risk insolvency. According to a report published earlier this year by the energy consultancy Wood Mackenzie, if governments succeed in adhering to the 2°C limit set by the Paris Agreement, we can expect oil prices in the range of $37-42 per barrel by 2030. Our research, based on historical modeling of price elasticity, current government policies, and expected EV production, predicts a sub-$40 crude price already by mid-decade, perhaps going so low as $20. At this price, billions of barrels of oil will become unprofitable to extract, meaning companies will be forced to write off these reserves as “stranded assets” and incorporate the costs of abandoning wells into their balance sheets. Such write-downs have profound effects on an oil firm’s valuation and its ability to finance operations and future projects. To avoid insolvency firms will be forced to diversify, moving sooner than later into more price-stable renewables.
Just as countries did in the late 1970s and early ’80s in response to their own energy crises, attendees at COP26 will discuss offloading price (and geopolitical) risk by decreasing their dependence on fossil fuels. Already, the world is on pace to replace twenty-five percent of ICE vehicles with EVs sometime between 2025-2030, effectively breaking Big Oil’s monopoly on transportation fuels and lowering energy prices for consumers. Governments should consider capturing part of these savings through a tax on oil below a certain threshold price, say, fifty dollars per barrel, and use the proceeds to pay for green infrastructure (thus further accelerating the transition). A key feature of the tax is that it isn’t experienced by the consumer at the pump as a price rise, since prices would be falling overall. By embracing oil’s inevitable decline, governments can more easily implement thoughtful and bold plans that better serve their citizens, present and future. World governments have already dipped their toes into renewables, and the water’s fine. It’s time to jump in.